Local Investments Give Mutual Fund Managers the Edge Research by Tobias J. Moskowitz
Finance theory prescribes holding well-diversified portfolios
to reduce the overall risk of your investments. Yet, most people
tend to hold poorly diversified portfolios, and heavily favor
domestic stocks over international stocks. New research linking
geography and mutual fund performance suggests that having the
right information makes local investments much more attractive
In their paper, "The Geography of Investment: Informed
Trading and Asset Prices," Tobias J. Moskowitz, assistant
professor of finance at the University of Chicago Graduate School
of Business, and Joshua D. Coval of Harvard Business School
examine the mutual fund industry to determine why people would
prefer to invest in stocks of companies located near them.
Professional mutual fund managers are expected to maintain
a diversified portfolio of funds by trade, and are not expected
to succumb to biases for local stocks. Though most research
suggests that mutual fund managers typically fail to beat the
market with their investments, Moskowitz and Coval present the
first evidence that some managers do better than the market
and their competitors, but only in their selection of local
The authors studied the holdings of mutual funds that were
actively managed over the past twenty years and found that fund
managers earn higher than expected returns in their local stocks.
In particular, the most agile funds, those that are small with
few holdings, and managers with the strongest investment community
ties (e.g., older managers located in remote areas) exhibit
the greatest gains from local investment. Large, young funds
from competitive and dense markets exhibit no such performance.
This new finding suggests that fund managers earn higher returns
as a result of information they have acquired about local companies,
giving them greater ability to select local stocks. The average
fund manager generates an additional return of 2.67 percent
per year from local investments, defined as holdings within
approximately sixty miles of the fund headquarters, relative
to out of town holdings. In addition, local stocks avoided by
fund managers underperform the local stocks they hold by a risk-adjusted
3 percent per year.
Managers with the best local stock selection abilities, and
presumably the most information, tilt their portfolios as much
as 20 to 25 percent toward local stocks, reaping the largest
gains from local investment. Local stocks held by these fund
managers outperform out of town holdings by as much as 3 percent
"We don't necessarily believe that mutual fund managers
have an exceptional ability to pick stocks. It's rather that
some fund managers are gaining access to private information
that others can't," says Moskowitz.
Connections that Count
The authors first matched the location of every fund manager
to the headquarters of the stocks they owned, and then tracked
each fund's quarterly holdings from 1975 to 1994. They measured
the degree of local bias by determining the dollars actually
invested in local stocks relative to the potential dollar investment
that exists locally. The remaining holdings were classified
as distant stocks.
While their results suggest a method of identifying informed
investors, the authors caution that the success of local managers
is difficult for outsiders to replicate.
"If I can see that a fund manager in Arkansas is buying
stocks A, B, and C, and selling D, E, and F, I can mimic that,"
says Moskowitz. "But funds only report their positions
every three to six months, as required by the SEC. So by the
time I try to duplicate all their local positions, they could
be six months old, and I won't make any profits."
A variety of fund characteristics affect stock selection ability,
including total asset value, numbers of holdings, and age of
the fund. Moskowitz and Coval also classified funds by metropolitan
location: large cities (funds in the 20 most populated cities);
small cities (funds not located in any of the 20 most populated
cities); and remote cities (funds located at least 150 miles
from any of the 20 most populated cities).
The funds with the largest assets show less local bias than
small funds, and unlike small funds, do not produce higher returns
on local investments. Similar results emerge from comparisons
of funds according to the number of holdings. These results
support the hypothesis that information plays a key role in
local stock selection ability, because small funds with few
holdings are better able to monitor local information and pursue
active trading strategies.
The oldest funds in the study also weigh more heavily in favor
of local stocks, and their local holdings outperform out of
town holdings. The youngest funds exhibit no such bias, and
show less ability to select well-performing local companies.
Moreover, funds from large cities show only a modest amount
of local bias in their holdings, while funds from small, remote
cities show a large local bias and perform above average in
their local investments. The more established community ties
and relationships of older managers in remote locations with
few competitors provide these managers with a local information
Although part of this local advantage may be access to private
information from local firms, proximity to local firms also
lowers the travel, time, and research costs associated with
obtaining information. Investors located near a firm can visit
its operations, talk to suppliers and employees, as well as
assess the local market conditions in which the firm operates.
"What's really driving these effects is perhaps a handful
of managers in the smaller markets who have close connections
with the local business community," says Moskowitz. "We
think of it as a 'country club effect,' since in a small community,
mutual fund managers may run in the same circles as CEOs of
local companies, and some information may move back and forth."
Why Not Go Local?
Overall, the study shows that fund managers with superior ability
to identify promising local stocks focus their investments locally,
while funds with no such ability choose to hold a more geographically
Why don't funds hold even more local stocks? Given that local
investments perform better, Moskowitz and Coval suggest that
fund managers should specialize entirely in local stocks, allowing
investors to diversify across all the different local mutual
funds. However, the structure of the mutual fund industry is
such that fund managers' careers are dependent on asset growth
and large clienteles. This provides little incentive to focus
exclusively in small local markets. Moskowitz suggests that
the mutual fund manager who starts out in a small city and becomes
successful is likely to move to New York to work for a large
mutual fund rather than staying and capitalizing on local information
Regarding the evidence of local bias among mutual fund managers,
Moskowitz adds: "People who hold mutual funds might want
to find out how well diversified those portfolios really are."
Tobias J. Moskowitz is assistant professor of finance at
the University of Chicago Graduate School of Business.